Dividend Smoothing in a Multi-Period Model of Signaling with Moral Hazard

This paper helps to explain the dividend patterns of large corporations by presenting a dynamic model where payout based incentives simultaneously mitigate opportunistic actions (perquisites) and induce managers to convey inside information to the market. Incentive compatibility links the manager's marginal cost of dividends to her marginal utility from perquisites. To induce value revelation (signaling), perquisites must increase with performance. Higher perquisites, however, reduce cash flows (precisely what dividends signal), leading to dividend payments that are smoothed relative to current earnings, total expected cash flows, and share prices, as well as smoothed across time. This smoothing is established for the set of incentive functions that control simultaneous adverse selection and moral hazard via the first order approach to managerial decision-making